Question

Yield to call

Six years ago the Templeton Company issued 24-year bonds with a 14% annual coupon rate at their $1,000 par value. The bonds had a 9% call premium, with 5 years of call protection. Today Templeton called the bonds.

A) Compute the realized rate of return for an investor who purchased the bonds when they were issued and held them until they were called. Round your answer to two decimal places. _______%

B) Why the investor should or should not be happy that Templeton called them. (Select One)

I. Since the bonds have been called, interest rates must have risen sufficiently such that the YTC is greater than the YTM. If investors wish to reinvest their interest receipts, they can now do so at higher interest rates.

II. Since the bonds have been called, interest rates must have risen sufficiently such that the YTC is greater than the YTM. If investors wish to reinvest their interest receipts, they must do so at lower interest rates.

III. Since the bonds have been called, investors will receive a call premium and can declare a capital gain on their tax returns.

IV. Since the bonds have been called, investors will no longer need to consider reinvestment rate risk.

V. Since the bonds have been called, interest rates must have fallen sufficiently such that the YTC is less than the YTM. If investors wish to reinvest their interest receipts, they must do so at lower interest rates.

Answer 1

Given:
Par value = $1000
Annual coupon rate = 14%
Coupon = 14%*1000 = $140
Call premium =9%
Realized rate of return = i = ?
Bond has been called off in period = 9

The price at which the bond is called, Px = 1000 + 9% * 1000
                                                                 = $1090

Realized rate of return can be calculated in excel as follows:
=Rate(nper,pmt,pv,fv)

Nper = 6
pmt = 140
PV = -1000
FV = 1090

=Rate(6,140,-1000,1090)
=15.03%
Realized rate of return is 15.03%

B) Why the investor should or should not be happy that Templeton called them :

Option V
Since the bonds have been called, interest rates must have fallen sufficiently such that the YTC is less than the YTM. If investors wish to reinvest their interest receipts, they must do so at lower interest rates.

Thus, investors would be unhappy when the bond has been called as they will now earn lower interest rate when reinvesting them.